Politics & Policy

Hubbert’S Holes

The higher-oil-price hypothesis forgets about substitution.

It was geologist Marion King Hubbert who argued that the life of any oil well resembles a bell-shaped curve; that production increases to a peak by the time half of the oil is pumped. After that, production inexorably declines. Applying his theory, Hubbert forecasted that oil production in the lower 48 states would peak in the early 1970s. His forecast was right on the money.

#ad#Some geologists are now arguing that the Saudi Arabian fields are on the verge of peaking. Given the Saudi’s forecasts on existing fields and the fact that discoveries of new fields are few and far between, the Hubbert theory neatly points to a secular decline in the supply of oil, making it easy to argue, under some general conditions, that oil prices may rise even further. The fact that nominal oil prices are now approaching levels seen only during the heyday of the OPEC cartel lends support to the higher-oil-price hypothesis.

Yet, even if every fact cited above is correct, there is still not enough information available to make definitive inferences regarding the future path of oil prices. One point being missed by the Hubbert-curve crowd — a group now arguing that energy prices will continue to rise in real terms — is that the supply-side of the oil market is at best only half the story.

The demand side is equally important. To illustrate this, we need to review some U.S. history. Hubbert may have been right in the 1970s, but his curve failed in the 1980s when energy prices came tumbling down.

Oil production in the lower 48 peaked in 1970 at 9.4 million barrels a day, and has since declined to 4.8 million barrels a day. The secular decline in domestic production of oil can be depicted as an inward shift in the supply curve for domestic oil. Given domestic consumption, the secular decline in U.S. production of oil in the 1970s resulted in a secular increase in the demand for imported oil.

But that was not all. Domestic price controls and environmental controls further restricted drilling and production of domestic oil and other fuels, thereby increasing the demand for “sweet” foreign crude oil. Price controls on natural gas and oil production, along with the windfall profits tax, effectively capped domestic prices well below market-clearing prices.

Ironically, price controls and the emphasis on supply-restricting “conservation” in the U.S. (such as limiting offshore drilling) reinforced the secular decline predicted by Hubbert’s theory.

The net effect of the U.S. energy policy in the 1970s was to increase the level of imports and reduce the elasticity of demand for imported oil, magnifying the negative effects of oil-price controls. Even worse, the environmental regulations channeled all the incremental demand for energy into sweet or light crude — and there was only one area of the world that produced light crude oil. Add to that the effect of conservation, and U.S. demand was made much less elastic, thus enhancing OPEC’s monopoly power. Viewed this way, the U.S. was, albeit inadvertently, the most important member of the OPEC cartel three decades ago. The combination of Hubbert’s theory and U.S. policies created the perfect energy-price storm.

The 1980s, however, showed us the power of incentives. The decontrol of crude-oil prices changed the shape of the domestic oil-supply curve in two important ways. First, it shifted out the domestic production curve, which had the effect of reducing the U.S. import function. Second, the price decontrol increased the price elasticity of U.S. demand for imported oil. In addition, efforts by the Reagan administration to ease environmental constraints increased the availability of oil substitutes. This, too, made demand for oil in the U.S. more sensitive to changes in price.

Collectively, the actions by the U.S. reduced the demand for imports and increased the price sensitivity of the U.S. import function. All of which weakened the cartel’s monopoly power.

In 1981, Kevin Melich, Chuck Kadlec, Gerry Bollman, and I used a similar type of analysis to argue that oil prices would decline to $24 a barrel and gasoline prices would fall to $1 a gallon as a result of the Reagan administration’s energy-deregulation program. We received some interesting responses to this position, mostly from industry experts who said we didn’t know what we were talking about and that oil prices were going to remain high for the foreseeable future.

Yet events proved our analysis right. (Sometimes a little economic analysis can go a long way.) Events in the 1980s also proved that you can’t place all your bearish chips on Hubbert’s theory.

The Hubbert effect was in full force during the 1970s and 1980s. The differentiating variable between the two periods was the price elasticity of the world demand for oil. During the 1970s, U.S. energy policies increased U.S. dependency on foreign oil and reduced the price elasticity of demand, thereby increasing OPEC’s monopoly power. In spite of the secular decline in U.S. oil production, the 1980s policy of energy deregulation increased the elasticity of demand for oil, thereby reducing OPEC’s monopoly power.

Decontrol was the source of the demise of the OPEC cartel, even though Hubbert’s theory was in full swing. Today, the market price of oil is still being determined by market forces — not by a cartel. More, plenty of substitutes exist to prevent oil prices from getting out of hand.

The substitution approach is a powerful way to see how OPEC has lost its monopoly power and why the constant-dollar price of a barrel of oil has remained for the most part in a trading range. It also shines the light on how the barrel price of oil will move back into the $20 to $30 range.

Today’s deviation from the long-run price range is easily explained. There is an increase in the demand for oil by “new” players in the world economy. India and China are growing at phenomenal rates. Given their level of technology, the derived demand for crude oil per unit of GDP is higher than that of the U.S. On the supply-side there are some cyclical shortfalls, most notably Venezuela and Iraq. The political difficulties in both countries are obvious and it is easy to understand that in the long run their production levels will increase.

While it is true that the secular changes described in Hubbert’s theory exist, the fact remains that there are plenty of energy alternatives today. Oil remains the premier global fuel, followed by natural gas and then coal. However, technological innovations in fuel-cell technology are weakening oil’s grip on the leadership position. Technological innovation is also increasing the substitutability of different fuels, which has distinct implications in terms of the equilibrium prices of the different fuels.

Ask yourself this: If the price of energy remains high, and is expected to stay so, how long will it take before certain countries outside the U.S. build nuclear power plants? Clearly the environmental issues that delay the building process and increase the costs of nuclear power plants do not exist in may parts of the world.

Much is said in the press about the supposed monopoly power of the OPEC cartel. But OPEC’s market power is fairly limited. OPEC members can flood the oil market and thus lower the price of oil, but it’s doubtful they will be able to keep the barrel price higher than the equilibrium range for long. The Saudi’s understand this. Even though they control 30 percent of the world’s oil, they are worried about substitution effects.

Here’s what Adel al-Jubeir, foreign-policy adviser to Saudi Crown Prince Abdullah, has to say:

For us, the objective is to assure that oil remains an economically competitive source of energy. Oil prices that are too high reduce demand growth for oil and encourage the development of alternative energy sources.

These words are not those of a monopolist. Rather they’re those of a producer worried that substitutes may be developed that will take market share away from his main product.

The implications of substitution effects are fairly clear. The price of oil will fall once again between $20 and $30 a barrel. Meanwhile, Hubbert’s devotees can wax nostalgic about the 1970s.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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